What $20 for the umbrella? How greedy can this street vendor get, gouging customers when it is raining? It’s a ripoff!

You probably made similar statements about different small-business. What am I saying, you don’t stiff the small businesses you only heard your friends make such statements.

What is the big deal here?

As long as one has options why should anyone complain about pricing? If one is complaining about pricing isn’t it likely one is not the customer the small business has in mind?

Why is the question, “are the umbrella prices a rip off?” vs. “What is the umbrella worth to me when caught in the rain?”

Granted the small business owner got her pricing wrong and most likely doing markup pricing with fixed cost allocation but that does not mean one can express outrage at the pricing.

Any price, however the business arrived at it, is not fleecing, rip-off, gouging or despicable. And it should not matter to a customer what it costs them to deliver the product, you pay for value. I wrote the same line for business owners – a business’ costs are just that, not something they can pass on to their customers. Same works here for customers.

So what they charge $5 for eggs they got for free? If the customers perceive value in consuming those at particular point in time and see that as better choice over all alternatives then it is fair pricing. If there is no value, you are not the target segment, so don’t blog about the atrocity.

If one insists on demanding fair pricing that is based on what it costs the business to make one should pick on the big guys who are writing the book on profit maximization, not the small business owners.

It is safe to say that those willing to share are most likely couples and they likely pay for it from the same shared budget. For everyone else, those not sharing budgets, the question of sharing does not even come into play.

A restaurant’s goal is to maximize spend per table. Their wait-staff are essentially the sales team trying to generate more sales per table during the period it was occupied.

So when customers share, it cuts (almost in half) the spend (and hence profit) per table. To discourage customers from doing so, they make the price of the single entree look a little more unattractive by adding the split fee. This is second degree price discrimination. With the split fee, customers may see higher value (consumer surplus) when they order two vs. one.

For those who still want to share for any number of reasons including limiting portions, even with added fee sharing will provide higher consumer surplus and the restaurant gets to recoup profit.

Why charge different split fees? Price discrimination done right. If you charge one split fee, you might as well charge two.

Should they do it? What about customer backlash?

To repeat my earlier point, this is a limited segment that will share food. The rest won’t even notice the split fee. So by all means do it as this is money that flows straight to bottom line. However they should consider their customer mix and capacity utilization.

What does this mean to you as a Tech Product Manager?

I do not recommend you following in the restaurant’s footsteps. Start with the customers and their needs. Consider how your webapp is being used by your customers.

Do they share login?

From what budget are they paying for it?

Is there value for them in keeping separate logins?

Do they want to keep their Netflix video queue/history or Evernote clip archive separate?

Do they consume your limited capacity without adding to revenue?

My recommendation: Instead of trying to tack on split fees, make the price of adding second (or third) user attractive that most will do it. (Like SurveyGizmo did)

There are rumors in Tech Blogs that Apple might introduce a cheaper iPad – could be a 8GB version or a 7-inch version, priced close to $299. The argument goes, Apple does not want to yield the lower priced tablet market to Amazon. If Amazon took the risk to invest in 7-inch tablet and uncover a market for it, there is likely no risk for Apple to take its share of the market.

So should or will they do it? (Let us not consider here what Mr. Jobs said about 7 inch tablets)
If three to five million people bought 7-inch tablets in the last two quarters, isn’t that an opportunity for Apple? Not to mention, those who are on the sidelines, because they did not like Kindle Fire and could not afford $499 price tag may enter the market, expanding the pie.

All highly likely scenarios. But there is a third scenario of similar likelihood that most ignore when making a case for introducing a new lower priced version of the product. It is those who currently buy their $499 version switching to the $299 version.

Without going into the details of Second Degree Price discrimination here is a brief description. When there is no $299 version of iPad, if the $499 version offers you enough consumer surplus you will buy it. When there is a $299 version as well, you will pick that instead if it delivers more consumer surplus than the $499 version.

The question Apple will ask (but not the Tech Blog savants who are often wrong but never doubt their claims) is,

Is the foregone profit from those trading down made up by profit from new customers we acquired?

You can see their track record of past product versions (iMac versions and MacBook Air versions) we can say with high degree of certainty that Apple will ask this question.

If we used the previously published numbers by iSuppli and others on cost of iPad, it costs Apple about $249 to make $499 iPad. Say their gross margin remains the same for $299 iPad (i.e., cost drops to $149). Then for every customer trading down from $499 to $299 version, Apple has to bring in 1.67 new customers.

That is just to break-even the trading down customers. In addition they need to find millions more to justify their investment.

Can they do it?

Side Note 1: When you uncover a new market or spend your resources to develop a new market, it is not all yours. Others will swoop in and get their share.

Simple answer, nothing happens to the sweater. Yes, it is the same sweater. It is the mix of people (customer mix) that changes from 6AM to 9AM (or later).

As customers we all have different prices we think is fair to pay for the sweater. Here, by fair I mean the price that we willingly pay without feeling pain. Let me use a very simple example with hard restrictions to explain why the price doubles from 6AM to 9AM.

Let us say there are only 100 people, numbered from 1 to 100. Each person is willing to pay a price that is less than and up to their number ( person numbered 10 willing to pay up to $10 etc). Even if it is a penny less, they will buy the sweater at the price.

Let us also assume the sweater costs the store $9.99 to buy.

If the sweater is priced $59.99 all the time, all those numbered from 60 to 100 will buy it, netting a profit of $2050 for the store.

If the sweater is priced $29.99 all the time, all those numbered from 30 to 100 will buy it, netting a profit of $1420 for the store. Note that all those numbered 60 and above will still buy it at this low price (the difference between their number and the price they pay is heir consumer surplus).

(Higher price netting higher profit is just an artifact of choosing these numbers, and not because higher prices drive higher profits)

But what if the store can sell the sweater a $29.99 only to those numbered between 30 and 59 and sell it at $59.99 to those numbered 60 to 100? They would make a total profit of $2650. (If one price is good, two seem to be better.)

The problem is these 100 people don’t show their numbers to the store and even if they did the store cannot force them to pay based on their number.

But what if there is a way to separate most of those of those in the 30 to 59 range from those in the 60 to 100 range? Conversely what if there is a way to keep most of those in the 60 to 100 range to pass on the $29.99 deal?

One such way is changing the buying experience. Create enough pain in the buying experience , like asking them to skip sleep, wake up early and schlep to the store at 6AM, such that most (if not all) in the 60 to 100 range will find it not worth it, just for getting additional consumer surplus. That is why there is a 6AM deal.

Most in the 30 to 59 range will likely do that sacrifice to score the sweater at lower price.

It is not ideal. Not all numbered 30 to 59 will come at 6AM and some from 60 to 100 may sacrifice sleep and family time to come at 6AM. As long as there are at least 5 people numbered between 30 and 59 come at 6AM for every 2 people in the 60 to 100 range, the store will do fine.

So there you have it. That is a simplified definition of price discrimination, customer willingness to pay and price versioning.

You may think I make similar claim too. Well, am I on solid ground making a comment like this with bold claim?

If one price is good, two are better.

It states that if it were possible to sell a product profitably at one price, it is certain that there will be higher profit from two prices. Note that the profit here means Price less marginal cost and does not include fixed cost. You might find there are other cost components that make the second price untenable. But that is a factor you can control.

It is impossible for me to re-do years of economic research on consumer surplus, price discrimination and other economic works. The statement I make relies on those works first started by Pigou.

The point to note is that my claim is not inductive logic. It does not follow from this statement,

“if two prices are good, three are better”

Yet, I did not address adequately the certainty in this claim. Shouldn’t this claim be more like,

“if one price is good, two are likely better for most situations”

No.

Let us rely on the works of Thomas Bayes for this (P is the probability)

What I am stating with my claim is,

P(2 are better | 1 is good) = 1 and not

P(2 are better) = 1

That is a huge difference.

The first probability statement is conditional probability. It is the equivalent of stating, “you picked a random card from the deck, if it is Jack of Spade, then we are certain that it is a face card).

It states that if it were possible to sell a product profitably at one price, it is certain that there will be higher profit from two prices. Either a moment’s reflection will convince you or you need to dwell into tomes of economic research.

The second probability statement is false. To see that we have to expand it

P(2 are better) = P(2 are better| 1 is good) . P(1 is good) +
P(2 are better | 1 is not good) . P(1 is not good)

As you can see from practice, P(1 is good) is a much small number than 1 and hence the it is not at all certain “two prices are always good”.

Ignoring all these, the net of these to you the marketer/entrepreneur/product manager is

If you find a market for your product at one price, you will find bigger market (measured in $$) at two prices.

When rumors about Apple’s iCloud started appearing I was surprised that they were getting ready to give up the biggest pricing lever they have – Flash Capacity. If files were stored in the cloud and streamed to the device then does it matter whether you have a 16GB iPad or 32Gb iPad? Will customers bother to pay more just to get additional capacity?

In the past I wrote at length on how Apple practices effective price discrimination with its pricing for Flash capacity in its iDevices. Here is the chart I used that shows the price curves for different iDevices.

How Apple prices Flash capacity has nothing to do with what it costs them. iSuppli breakdown showed that price difference between 16GB and 32GB iPad is only $15 while the price jump is much more than that.

Another noteworthy aspect of this Flash pricing is the price jump is not the same for all iDevices. As you can see from the chart, the curves get steeper as the screen size and functionality of the device increase. Clearly, the value from additional 16GB flash to an iPad customer is lot more than that for iPod or iPhone customer.

So the same capacity is priced differently based on the value to the customer.

The final and crucial piece of price discrimination puzzle is the absence of arbitrage. Apple completes its power to practice price discrimination by eliminating arbitrage (in this case alternatives). A simple way for customers to add more capacity is through extension slots but none of the iDevices provide that feature. So if we want more capacity we better be ready to pay more, lot more.

With iCloud is Apple likely to lose this pricing power by creating arbitrage? It would have if the files were really streamed from the cloud like Amazon and Google. But true to their pricing mantra of capturing all customer surplus upfront the iCloud solution does not permit any arbitrage opportunity for the customers. The Journal sheds more light on the iCloud implementation that is very different from that of Amazon and Google

Apple’s strategy, on the other hand, rests on consumers storing their content locally on their devices. Its new iCloud service allows consumers to easily sync their music collections to any of their Apple devices. Aside from the initial sync, a Web connection isn’t necessary.

In other words, the need for bigger capacity on iDevices still exists. Customers cannot trade iCloud capacity and streaming to offset the higher price premium they pay for bigger flash capacity. We will continue to pay $100 for our perceived need for higher capacity.

Apple will continue to capture value from commodity components.

Despite the competitions and the disruptions, Apple continues to retain its pricing power – built into their product DNA is the need to maintain pricing power. What we see is an example of perfect alignment of product and pricing strategy that helps them with the real business goal – profit.